Establishing Market Equilibrium Points

Market Equilibrium Process

Good luck finding a market that does not have some sort of government interference. Is there some sort of tax-free product, produced by an unregulated business, that I don't know about? Economic models are never based in reality, just a hypothetical world in which all external factors are stripped away, so that simple models can be built to understand how specific critical elements within these models relate to one another. So let's dispense with the silliness and get to work, looking at hypothetical products in a hypothetical free market. We are talking about the market for widgets.

The law of demand states that as the price of widgets increases, demand for widgets decreases. The law of supply states that as the price for widgets increases, the supply of widgets increases. The determinants of demand for widgets are price, the availability and price of any substitutes, and the availability and price of competing widgets. The determinants of supply are the price, the availability and price of inputs, and the opportunity costs of producing something other than widgets.

Efficient markets theory holds that the price of a good is at the equilibrium point in an efficient market. The aggregate demand and aggregate supply are equal at a particular point, and this point is at the equilibrium price.

Surplus and shortage occur under two conditions. First, they can occur when there is a distortion in the market. This will typically arise when there is something to disrupt the market. This something could be government interference, which can result in market failure and deadweight loss. Or the something could be a short-run misalignment of demand and supply. The equilibrium point is a theoretical point in economic models, but such a point does not really exist for any length of time in an efficient market. Consider the highly efficient market for stocks of any company with a high trade volume. The price at any given moment can be taken as the equilibrium point, but the next trade could very well move the price. The efficient market hypothesis when applied to equity assets holds that the stock's price movements reflect changes in the business (in real time, if you take this to the extreme). If your company was Starbucks, this is a company that is operating round the clock somewhere in the world, so in theory the stock could move based on changes in the perceived value of the future cash flows. That is the fundamental principle of efficient markets.

So a shortage or surplus of goods in a given market is usually taken to be temporary, and adjustment to a change in the external market for the good. Companies will adjust their production to meet demand, but there are invariably going to be gaps in information, and time lapses in decision-making. On the stock market, these can be remedied within minutes, but in the real world, shortages and surpluses even in a fairly efficient market can take days or even weeks to resolve. The ability of a market to restore long-term equilibrium following a short-run shortage or surplus is going to be affected by things like substitutes and competition as well. The different variables and time lags will end up creating some market inefficiency, as the natural equilibrium point continues to move faster than the companies in the industry can adjust, but this is all part of the natural equilibrium process. It is the major changes, such as a dramatic drop in demand, that will have an impact on supply and the equilibrium point.